Currencies allow for the efficient buying and selling of goods and services between individuals and countries and have been around since the stone age. The use of paper currency began in the 1690's with paper notes being issued by the Massachusetts Bay Colony to pay for military excursions. United States Notes or “green backs” were introduced in 1862 and backed by the U.S. Treasury's promise to exchange the notes for gold coin. In 1913, the Federal Reserve was created to provide stability in our financial system as well as to combat inflation and provide for full employment.
The strength of a currency is primarily affected by the following three things:
- Interest Rates: High interest rates tend to strengthen a currency however it's the interest rate level relative to other currencies that ultimately has more of an influence on currency strength.
- Monetary Policy: Countries that consistently demonstrate anti-inflationary monetary policy and fiscal restraint tend to have stronger currencies.
- Political Stability: A strong and stable government with a track record of policies supporting economic growth can attract investors and build confidence in a currency.
A strong currency makes exports more expensive and can lead to a trade imbalances with countries that have weaker currencies. Conversely, a weaker currency makes exports cheaper and tends to stimulate trade.
The U.S. Dollar Index is an index that represents the value of the U.S. Dollar versus a basket of foreign currencies. The dollar index was created in 1973 and started with a baseline value of 100. The index has seen a high of 164 during the Latin Debt Crisis in 1985 and a low of 70 during the financial crisis in 2008. The index is an important tool for currency traders because it shows the relative strength of the dollar versus the currencies of our major trading partners.
Currency Pairs & Exchange Rates
A currency pair is a quote between two currencies. The first currency in a currency pair is referred to as the “base currency” and the second currency is called the “quote currency”.
An exchange rate is the value of one currency expressed in terms of another currency for the purpose of conversion. As with any rate, exchange rates vary depending upon the strength or weakness of the currencies in question. Exchange rates are another indicator of the relative strength or weakness of currency pairs. For instance, stronger currencies tend to show positive exchange rate correlation over time when paired with weaker currencies. These currency pair trends can also provide insight into trade balances between countries.
Currency Strength & Monetary Policy
As we have discussed, currency strength affects the prices of goods and services for export and therefor affects the trade balances with foreign countries. Currency strength also plays an important role in setting monetary policy.
An “easy” monetary policy or lower interest rates has the effect of lowering the exchange rate, more expensive export prices, and a negative impact on trade balance.
On the other hand, a “tight” monetary policy or higher interest rates has the effect of a higher exchange rate, cheaper export prices, and a positive impact on trade balance.
Currency Pairs and Forex Trading
Forex trading involves the simultaneous buying of one currency and the selling of another currency. In addition to spot trades, there are opportunities like currency options trading which can be a hedge during times of financial instability or a relatively low risk instrument for speculative trading when the outcome is predictable. In other words, a trader may buy a currency pair if he believes the exchange rate will rise, or sell a currency pair if he believes the base currency will decrease in relation to the quote currency.